James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

The proposed bailout of Greece probably can’t escape the scarlet D of default, at least if the ratings agencies follow their own guidelines.

Even if the deal goes through, it is insufficient to solve Greece’s debt problems, only buying time for those involved to work out how best to engineer a transfer of bank losses to taxpayers.

Greece approved an austerity package on Wednesday, removing one road-block to further support, but it is still unclear how to get banks to participate in debt relief — a German requirement — without prompting a destabilizing event of default on Greece as a sovereign creditor.

French banks have proposed a burden-sharing plan, supposed to be voluntary, which EU officials are pushing as a means to thread this particular needle.

Under the plan, holders of Greek bonds maturing in the next three years would agree to roll over half of their exposure into new Greek 30-year bonds. Another 20 percent would go to fund a vehicle to act as collateral against Greek default.

The new Greek debt would have an interest rate of 5.5 percent, massively below Greece’s free-market funding cost, plus a potential sweetener of another 2.5 percent depending on Greek GDP growth.

Well, if it walks like a default and quacks like a default; it may just be a default.

This is a deal that is patently designed to avoid a default, and patently makes banks accept diminished economic returns, all important criteria of financial default.

Fitch ratings agency has already said it would very likely view such a deal as a default, and while the other agencies have not yet commented a look at their criteria points to a similar view.

Standard & Poor’s own definition of default labels a distressed exchange offer, “whereby one or more financial obligation is either repurchased for an amount of cash or replaced by other instruments” as a Selective Default.

Moody’s similarly considers a distressed exchange as a default, if either that exchange amounts to a diminished financial obligation compared to the original debt or, the exchange has the effect of allowing the borrower to avoid a payment default in the future.

The ratings agencies will be under massive pressure to bend their rules, so it is always possible that they, perhaps two out of three of them, allow the deal to skate through.

But why would the banks volunteer for this deal?

The French proposal cleverly allows banks to mark the new debt as “held-to-maturity,” meaning that they are not compelled to recognize their obvious losses. It also buys time, not so much time for Greece to recover, because the deal is not generous enough to allow that, but for EU politicians to work out some way for the losses to passed along to taxpayers to shelter the banks.

FORK IN THE ROAD

If the French proposal is labeled a default, it won’t go through, as escaping default is one of its preconditions. This leaves open the possibility of a disorganized default in coming months, an event that would be so destabilizing that Germany may eventually relent on its insistence that private creditors pay a share.

If Greece is downgraded to “default”, the ECB has said it would refuse to accept Greek bonds as collateral for liquidity loans, an act that would at a stroke vaporize much of the Greek banking industry. The obvious thing is for the ECB to bend its rules, but even if it did, you can expect that a Greek default would immediately bring Portugal, Spain, Italy and Ireland back into play, with investors declining to finance them, or even worse, pulling funds from their banks en masse.

Even if the French proposal goes through, it, in combination with the new austerity package has done nothing to lighten Greece’s debt load, only buying time for its economy to recover or for a different political reality to dawn. But Greece’s economy isn’t going to recover any time soon, given the weight of the debt load and the self-reinforcing dynamics of austerity. It will continue to contract, making the debt burden worse.

While the Greek economy needs to reform, that process will not be fast enough to solve these issues, and arguably will be retarded by the severity of the austerity.

Perhaps the hope is that in a year or so opposition to socializing Greek debts will ease in Northern Europe, allowing for a bailout that does not damage banks, or damages them less at a time they have been able to rebuild sufficient capital.
The overall impression is of an elaborate dance intended to shelter banks from damage they are not strong enough to withstand.

That’s not just unfair, and ultimately unproductive, it is a sobering comment on just how weak growth will be while the banks are allowed to heal.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

What do you call an entire economy which sweeps its insolvencies under the carpet and hopes that something will turn up?

Britain.

An investigation by the Bank of England, reported in its Financial Stability Report released on Friday, found widespread evidence that banks are extending loan forbearance to weakened borrowers.

And because loans in forbearance often aren’t classified as impaired, banks may be skimping on loan provisions, giving a deceptively flattering account of their capital position and health.

Forbearance, usually some form of break given to a borrower such as extending the term or making the loan interest-only, is offered to some borrowers when they miss a payment or violate part of the loan agreement.

What’s surprising about the BOE’s findings is how widespread the practice is, not only in residential mortgages, but in commercial real estate lending and corporate lending.

Commercial real estate, which has suffered deep and widespread declines in value, is the other shoe that never dropped for the British banking system. Perhaps this is because, as the BOE points out, around a third of all UK commercial property lending may have benefited from some form of forbearance.

The Property Industry Alliance believes that about 80 percent of all loans made for commercial real estate since 2004 may be in breach of their loan-to-value covenants. LTV covenants govern how much debt a borrower can have relative to the market value of their property and often include provisions requiring borrowers to accelerate repayment or contribute additional equity if they find themselves in breach.

“Contacts suggest that forbearance is one reason why corporate default rates in the UK have remained low relative to past recessions,” according to the report, which pointed out that the corporate liquidations rate was only 0.7 percent in the first quarter, compared to a peak of 2.6 percent in the less severe recession of the early 1990s.

The bank also said that as many as 12 percent of residential mortgages may be in receipt of some form of break on their loan. An earlier investigation by the Financial Services Authority found that 63 percent of all troubled home loans have been switched onto some form of forbearance. Some 3 percent of borrowers with mortgages totaling 60 billion pounds ($97 billion) have switched to interest-only mortgages, under which no principal is retired, since the onset of the financial crisis in 2007, according to the FSA.

So, there we have it; all significant parts of the British economy are being helped by loan repayment forbearance from a banking industry which is not sufficiently disclosing how it decides how it operates or if it is setting aside enough money for future losses.

The BOE asked the FSA to continue its investigation into residential mortgages and broaden it across UK banks’ residential and commercial lending globally.

SENSIBLE OR SELF-SERVING POLICY

The BOE was at pains to stress that it is not against forbearance per se. And indeed giving troubled borrowers slack, if handled well, can improve outcomes for all parties and for the economy itself. Putting masses of borrowers into default all at once can cause a vicious cycle of forced sales and falling prices, as we have seen in the U.S.

The clear priority, then, is to force banks to be more transparent about why they offer borrowers breaks and how they decide how much to put aside against possible eventual defaults. This will protect shareholders, who might otherwise pay out billions in bonus payments to bankers only to be left holding the bag when the loans eventually go bad. It will also, of course, protect those who lend to banks and the taxpayers who ultimately backstop them.

The larger question is whether all of this forbearance is simply putting off the inevitable, and slowing sustainable recovery as it does.

Japan’s example from the 1990s suggests that keeping so-called zombie borrowers alive leads to extremely poor economic outcomes. It ties up banking capital that would be better used supporting sustainably profitable businesses, as well as distorting competition throughout the economy.

There are two ways to look at this. The cynical, and quite possibly correct, way to view the mass forbearance is that, of course, this is what banks do when faced with failure, and they mostly get away with it. U.S and international banking history are littered with banks that in retrospect would have failed if they had played things straight, but lived to lend again by extending and pretending, almost often with the witting participation of their regulators. It doesn’t always work out too badly.

The second way is to look at this as not only a warning about the grave risks the UK banking system faces, but an indicator of exactly how weak the economy is and will be.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

The Bank of Japan seems to be running its own fun-house version of monetary policy, intervening in equity markets when they fall.

Dubbed by traders the BOJ’s “1% rule,” the central bank is apparently stepping in to buy Japanese shares on days when they end the morning down 1 percent or more on the previous day’s closing price.

While the BOJ will not comment on its purchases or policies, Japanese news organization Nikkei points out that since mid-December, the central bank has bought ETFs on each of the 18 days the Topix index fell by at least 1 percent in morning trading.

While it is hard not to be sympathetic to the BOJ, which is struggling to kindle both demand and inflation after the devastating earthquake and tsunami, the tactic of buying when markets fall sharply is more of the same failed medicine, only worse.

Such an implied insurance policy for investors only further distances stock valuations from reality, makes more likely lousy allocation of capital and, ultimately, sets up the market for a nasty bout of selling if ever the BOJ ends the policy.
It is also, very possibly, a foretaste of the kind of folly that might emerge from the U.S. Federal Reserve if the current economic lull deepens into a double dip recession.

While the amounts the BOJ is spending on buying shares is small in the scheme of things, it is having an important psychological impact on traders and investors, who have grown used to official buying if the market has a bad morning.

The BOJ in October announced a new policy of buying exchange-traded funds and Japan real estate investment trusts (J-REITs). The ETFs track the Topix or Nikkei 225 indices, while the real estate trusts must be AA rated or higher. The plan was part of a larger $61 billion plan to buy up a variety of assets, including corporate debt.

There is no way of getting around it; central banks buying shares are picking winners and losers in theeconomy and are moving ever further away from their core mandate of price stability. Why on earth would anyone think a central bank has a better idea of how to allocate capital in the economy than the sum of all market forces, even given how imperfect and prone to error markets are?

Why too would a central bank want to favour large listed companies and real estate over the rest of the economy? Why not buy used cars and junk them, or simply buy up office buildings and burn them to the ground? At least those actions, deranged as they are, would have an actual impact on supply and demand in the actual economy. As it stands, at best, the BOJ’s actions simply flatter people’s ideas of how much their financial assets are worth. At worst it simply facilitates cynical buying and selling by people trying to front run the BOJ’s assumed policies.

FEEDBACK MECHANISMS SHORT-CIRCUITED

This gets to the heart of the self-defeating aspects of much monetary policy, both in Japan and in the U.S., as it has been practiced in the last 15 years. One of the main effects of all that has been done, bailing out after crises, engaging in quantitative easing, is to short-circuit the normal feedback mechanisms that should travel between financial markets and the real economy.

It is very much like pain medication; good for temporary relief but a poor long-term solution. If you have an injured knee and take opiates to mask the pain you may walk a bit more in the short term, but perhaps a lot less over the long run. We’ve been upping our dosage since about 1998, and it’s not working well anymore.

Buying up equity and property-share funds may be the most extreme and egregious example, but it is probably not the most important. That honor belongs to buying up government debt, which has helped to nullify government bond markets as a benchmark by which the world can measure risk.

In the old days, and really this is before China began buying up Treasuries as an adjunct of currency manipulation, people thought of government bond yields as a north star against which the relative risk of everything else could be gauged.

Investors really have no idea where they are anymore, and in this way all of the efforts to suppress or mask risk by intervening in asset markets have only increased the likely amount of ignorant risk we are collectively taking on. The subprime and subsequent crises are examples of this, but surely won’t be the last.

This is surely throwing up attractive opportunities for clever investors, but is not likely good public policy.
For Japan and the U.S., as difficult as their respective situations are, the best thing would be to stop supporting asset prices and let the feedback mechanisms reassert themselves. They will in the end anyway.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

Financial repression, the capture by government of capital for its own needs, is coming, if it’s not already here.

If you are a saver, or just rich, for that matter, this means that some of your money will flow to debtors, mostly your government, in a kind of sleight of hand.

Financial repression, which takes many forms, has historically been a popular way for governments to dig themselves out of debt holes, as it can be slow and controlled, unlike a default, and, like the proverbial frog being slowly boiled, is hard for the victims to figure out.

“One of the main goals of financial repression is to keep nominal interest rates lower than they would be in more competitive markets. Other things equal, this reduces the government’s interest expenses for a given stock of debt and contributes to deficit reduction,” economists Carmen Reinhart, Jacob Kirkegaard and Belen Sbrancia wrote in an IMF publication.

“However, when financial repression produces negative real interest rates (nominal rates below the inflation rate), it reduces or liquidates existing debts and becomes the equivalent of a tax — a transfer from creditors (savers) to borrowers, including the government.”

That’s exactly what happened in much of the post-World War II era, and is one of the principal ways nations bailed themselves out of the debts incurred during the conflict.

How does it work?

There are many forms, but keeping interest rates artificially low, either through direct or effective caps is an important component of financial repression. Look no further than QEII for an example of this, but more may be coming.

Both Bill Gross of PIMCO and David Rosenberg of Gluskin, Sheff have warned that the Fed’s next effort at stimulus may come in the form of an interest rate cap of some kind. For example, the central bank may pledge to buy enough of a given maturity of government debt, let’s say the two-year, to keep rates capped at a given yield. That would be both stimulative and quite convenient from a debt management point of view.

Decoupling of interest rates and risk is a noted feature of financially repressed systems. Again, look at QEII as a prime cause, as well as purchases of treasuries by foreign central banks. This is one of the great dangers of financial repression; that in an otherwise lightly regulated market it unplugs the risk alarm bells that investors usually hear. The Chinese property market is a great example of this, as hugely negative Chinese real interest rates prompt speculation in Shanghai apartments.

After all, why keep your money in the bank or in bonds only to see it ebb away?

Note that a negative real interest rate, i.e. one that fails to compensate for inflation, effectively liquidates the underlying debt. That’s a stealth tax on capital holders and does not have to feature high inflation.

CAPTIVE INVESTORS

Financial repression also often features governments capturing investors, such as by forcing pension funds or banks to hold given amounts of government debt. There have already been great examples in Europe, such as Irish efforts to nobble pension money by forcing it to contribute to government bank bailouts. France has recently put in place measures that unfairly induce pension plans to invest in government debt, as has Hungary.

What is considerably different this time, as opposed to after World War II, is that so much of the debt is privately issued, meaning that it is not just government debt that needs clearing up but masses of private debt. Attempts to apply financial repression to the housing market have so far failed, after having worked only too well for decades. While the Federal Reserve bought up mortgage bonds, and the government massively subsidizes mortgage rates through Freddie Mac and Fannie Mae, this so far has not outweighed the fall in the value of the underlying real estate.

Another main feature of financial repression is closer ties between government and banks, either via ownership or suasion, and tighter regulation. Banks often tend under these circumstances to hold more government debt, and to lend more at home rather than abroad.

Look for all of this to happen in massive amounts if Greece falls out of the euro zone, and perhaps even if it does not.
For capital holders this is all a huge drag. If financial repression works this time, which it may not due to all of that private debt, look for investment in highly indebted companies and vehicles to work well, as theoretically would property. Gold would also outperform, theoretically, so long as investors are allowed to hold it.

The really remarkable thing is how attractive an unjust policy like financial repression looks given the dire alternatives.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

Greece, Germany and the European Central Bank appear to be petitioning for a divorce, not from each other, yet, but from reality, citing irreconcilable differences.

As in all such divorces, reality will get by far the best end of the settlement and it will be the children, or should that be the citizens, who suffer.

Greece, shut out of the capital markets, needs money, and soon, and is willing to play along with the fiction that the next tranche of aid, perhaps 90 billion euros, from the European Union, International Monetary Fund and ECB will buy them enough time.

The ECB, which is up to its eyeballs in exposure to Greek debt, steadfastly maintains that it won’t countenance a soft restructuring, or default, presumably because it fears this will be too much for it, the banks, and the global financial markets to bear.

Germany, however, is insisting on just that; it maintains that the private sector will have to bear some of the costs, and while there is much discussion about “soft” restructurings featuring debt repayment extensions, no one has credibly explained how the private sector can take its lumps without it being considered a default.

Standard & Poor’s on Monday slashed Greece’s debt rating to CCC, the lowest rating it currently has on any nation, saying what is obvious to everyone outside this particular marriage, which is that it just isn’t working any more.

“In our view Greece is increasingly likely to restructure its debt in a manner that, under the conditions of any package of additional funding provided by Greece’s official creditors, would result in one or more defaults under our criteria,” S&P wrote about its move.

“We are also of the view that risks for the implementation of Greece’s EU/IMF borrowing program are rising, given Greece’s increased financing needs and ongoing internal political disagreements surrounding the policy conditions required by Greece’s partners.”

The ECB has perhaps 40-50 billion euros’ worth of Greek bonds on its balance sheet, and has lent about another 90 billion or so to Greek banks. It has threatened, in the event of a restructuring, to stop accepting Greek debt as collateral, a move that would be tantamount to cratering the entire Greek banking system at once. This would also deal sharp losses to the many euro zone national central banks which are exposed, potentially causing some to need additional capital.

By destroying the Greek bank sector, the ECB would, quite possibly, effect the exit of Greece from the euro zone. Depositors in Greek banks understand this, and have been withdrawing funds. Two-year deposits fell 8 percent from a year ago in April, and savings deposits fell by 16 percent, according to Bank of Greece data.

PLAYING CHICKEN

Given all of this, it seems likely that the ECB will relent, though in doing so they will seriously impair their credibility.

Even if the ECB relents and decides that it will not be the one dealing death to Greek banks in the event of a default, what then? This is the problem with Germany’s position, which rightly demands private sector participation but isn’t nearly radical enough to actually get Greece out from under.

A Greek default, under the terms currently being debated, may turn out to be the worst of outcomes. It will raise the possibility of global market fragility without putting Greece on a sound footing. For example, though most direct exposure to Greece is held by European banks, there would be a high price to pay for U.S. institutions which have been selling default insurance on Greece. Economist Kash Mansori estimates that U.S. institutions would actually bear more of the total losses than German ones, a state of play which perhaps partly explains German hardball tactics.

The terrible irony is that even if the parties can agree a course, none of the courses they seem likely to agree will leave Greece able in two years’ time to fend for itself. That mooted 30 billion euros of private sector burden sharing is just a down-payment. And of course, as soon as Greece defaults, the eyes of the market would immediately turn to Portugal, Ireland and even Spain.

The problem with the European approach to its weak states is that the scope has been too narrow. Rather than figuring out how to keep Greece upright without knocking over the banks, they would have been far better off figuring out how to actually make the banking system solvent and sound given Greek insolvency. That would involve huge private sector losses, inevitably, but might just have laid the groundwork for sustainable growth.

Instead we will have a sinking euro and waves of deflationary force coming out of Europe.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

Jamie Dimon is just doing his job, which is why it is more important than ever that Ben Bernanke do a better job at his.

Dimon, JP Morgan Chase & Co Chairman and CEO, staged an unusual confrontation with the Federal Reserve Chairman at a conference in Atlanta on Tuesday, drawing a line between tighter banking regulation, heavier capital requirements and slow growth and joblessness.

“Has anyone bothered to study the cumulative effect of all these things?” Dimon asked.

“And do you have a fear, like I do, that when we look back and look at them all that they will be a reason it took so long that our banks, our credit, our businesses and most importantly, job creation, started going again?”

Well Jamie, I have other fears that outweigh yours; that you, your bank and others like it will use your positional advantage to extract wealth from the economy which exceeds, on a risk-adjusted basis, the value you add. What’s more, you will do so by arbitraging a government guarantee that will allow you to make profits all the while building risks that, when they explode, will become taxpayer liabilities.

The very nature of his question, with its overtones of holding the economy hostage, are evidence of the unsavory and unacceptable relationship between finance and the rest of the economy.

Dimon was reacting not just to the patchwork of new regulation enacted since the crisis, but to recent proposals for higher capital weightings. Fed Governor Daniel Tarullo last week said the Fed was considering capital requirements that could end up being more than double those envisioned under the international Basel III plan. Also on the table is some form of extra capital weightings that would penalize banks based on their size. This, meant to encourage too-big-to-fail banks to slim down, is a dagger aimed directly at Dimon and J.P. Morgan’s unfair advantage.

It would impair his profits, and, as Dimon argues, would hit the economy.

He’s exactly right, of course: higher capital requirements and better supervision will crimp economic growth, perhaps imposing a lower ceiling on the booms we have grown to love and fear. After all, the freely available credit of 2006 created many jobs, from originating no-doc mortgages to fitting marble bathroom fixtures.

There are two problems with this type of growth; it is a wasteful misallocation of resources, and also the growth is ephemeral. Financial crises are hugely damaging, and as we are seeing, the recovery is long and painful. That is an illness which more bank intermediation will not cure.

It’s Bernanke’s job to recognize that he is not charged with creating growth at any price, but at fostering sustainable growth. That means tough banking regulation, aggressively enforced.

HOW MUCH FINANCE IS TOO MUCH?

Even beyond the issue of too-big-to-fail there are real questions over how large a financial system is actually beneficial to an economy. Because the U.S. subsidizes finance, through deposit insurance, mortgage support and in many other ways, this is an appropriate area for government control.

A recent paper by economists Jean-Louis Arcand, Enrico Berkes and Ugo Panizza explores the relationship between the effects of financial development and economic growth.

While there is little doubt that finance is important in an economy, the authors found that after a certain point the effects of more financial intermediation are actually negative for growth. The high-water mark is when credit to the private sector is 110 percent of GDP; after that our banks are, in effect, a tax, privately levied but publicly paid.

All of the major economies are above that 110 percent threshold. The U.S. is among the most debt-ridden, with credit to the private sector at more than 200 percent of GDP in 2009, according to World Bank data.

On that basis, higher capital requirements and tighter regulations are an unalloyed good. Growth may be lower at times, but there will be less of the ruinous ups and downs. Importantly too, the fruits of growth will be more fairly shared out, between industry and government, among industries and among individuals.

“They’re concerned about their return on equity, and I’m concerned about the safety of the banking system and the American depositor and taxpayer,” Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, told American Banker.

“All the safety net has done is allowed them to leverage up to their advantage on the backs of the American taxpayer. I have a hard time as a person, who is more concerned about the safety of the system and the taxpayer, to worry about their position.”

This is exactly the approach Bernanke should take.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

First came the realization that U.S. economic growth was fading. Now comes the dawning feeling that no meaningful help is on the way.

There is no sign of significant new stimulative government spending and little chance that the Federal Reserve will be willing, much less able, to follow up with another round of quantitative easing.

As for the global economy, Europe is in its own crisis and that transition to a consumer economy in China is going to take a while.

For investors used to more than a decade of bailouts, this will be a rude shock and will follow the usual pattern of denial through to acceptance.

Government bonds will get yet another boost, as will the U.S. dollar, while equities and other expressions of risk appetite will get pummelled.

Friday’s jobs report brought home just how feeble the U.S. economy is with non-farm payrolls rising by just 54,000 in May, about 100,000 less than is needed to merely keep employment stable. Private sector hiring was disappointing, but so too was government employment, which has been on a long, slow descent.

The data merely confirmed what was already apparent: economic growth began to slow in the first quarter and has slowed further as the year has gone on.

While lots of attention is paid to the things that have changed and are hurting the economy — energy prices and freak weather — the fundamentals driving the economy are really unchanged. Households have too much debt, supported by too little earnings and secured against, in many cases, assets with diminishing value like real estate.

The Pavlovian response among investors has been to figure that a weak economy and weakening markets will bring further government stimulus; after all for many that’s all they have ever known.

This time is going to be different, for good or ill.

“We have shifted in the economy from a rescue phase, which is government-directed, to a phase in which we’ve got to rely on government policies that are trying to leverage the private sector and give incentives to the private sector to be doing the growth,” Austan Goolsbee, the head of White House Council of Economic Advisors said on ABC television.

While Goolsbee may believe this, it wouldn’t matter if he didn’t because the Administration has little choice but to hope the private sector can do something; the public sector will not.

While there are proposals for stimulative measures — like an infrastructure bank — they are either blocked in Congress by Republican opposition, are too small to make a difference, or both.

POLICY STALEMATE

This is the great unaccounted-for cost of the TARP and other rescue plans dating from 2008. They poisoned public opinion against all government stimulus, tying the hands of the current Administration and very likely of future ones.

The debate has moved firmly towards budget cuts, and while those are an ultimate necessity, the market has not quite caught up with their economic implications. It is not just bureaucrats who will be thrown out of jobs, private sector employment and profits will take big hits too.

As for the Federal Reserve, things would have to get a lot worse, as well they may, before they can be expected to weigh in with another round of QE. While “QE2″ fulfilled its aim in driving equity prices up and the dollar down, there is genuine controversy over what the risk/reward trade off actually is.

Federal Reserve vice chair Janet Yellen last week acknowledged that, taken too far, the sort of “reaching for yield” the Fed has engineered can lead to dangerous financial imbalances.

Almost more to the point, even if the Fed wanted to go further with extraordinary measures it faces real political risks and costs if it does. QE2 has been very unpopular in certain quarters. This is partly because of fears of inflation, but also because many Republicans view it as fiscal policy by another name, and its use as a unilateral infringement of Congress’ powers.

Wrong this may be, but it will be increasingly difficult for the Fed to act again as the 2012 election cycle kicks off, raising the bar for further action.

So, how does this play out in financial markets? It is very positive for government bonds, even in the face of the debt ceiling negotiations. The economy is doing poorly and will get little further support. The dollar should do well too, as investors come to realize that there will be no additional (virtual) money printing.

For equities and other risk assets it will be, of course, bad. It will take a while for the new reality to sink in, but when it does look for conditions that are just bad enough to bring consensus on rescues, stimulus and extraordinary measures yet unimagined.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — British banks are being surprisingly generous with troubled homeowners, raising red flags over the health of the housing market and their own earnings.

An investigation by Britain’s Financial Services Authority found that 63 percent of all troubled home loans have been switched onto some form of forbearance, typically ones that make the loan interest-only or extend the repayment period.

Some 3 percent of borrowers, or 300,000, with mortgages totaling 60 billion pounds ($97 billion) have switched to interest-only mortgages, under which no principal is retired, since the onset of the financial crisis in 2007, according to the FSA.

Most of these loans have no provision for saving to pay back principal, and in the case of one lender the FSA found that more than 95 percent of borrowers seeking to switch to an interest-only deal were in financial distress, raising grave doubts about whether the loans will ultimately be repaid.

Yet loans under forbearance are not listed as being in arrears, giving a deceptively flattering account of banks’ health.

“We require firms to report accurately and transparently the impairment of their mortgage book. We did not generally observe this,” the FSA said in its report.

It would be very easy to conclude that banks are performing an extensive “extend and pretend” exercise with the entire UK housing market, extending terms to borrowers who cannot ultimately afford to pay the money back in order that the bank can avoid recognizing the losses.

Write-off rates on loans to UK households — at less than 1 percent — are currently about where they were in 2001, according to Fathom Consulting, even after a deep recession and a 20 percent fall in house prices.

The British market has been spared the deluge of forced sales of houses that has made the U.S. housing crash more severe — little wonder given how accommodating the banks have been.

While it is possible that mass loan forbearance “works” as a policy, allowing homeowners to stay in their houses until the economy and their own fortunes revive, it is a gambit where banks take risks with other people’s money. Many borrowers with limited income and high debts would be better off letting the house go, especially if the current weakness in the housing market gathers pace. Bank shareholders and lenders to banks have reason to complain that banks are taking their funds without giving them a fair view of the risks. And lastly, of course, the British government is the ultimate bag-holder if it all goes wrong and they are forced, again, to guarantee bank debts and make them good.

LIAR LOANS REDUX

Interest-only loans are in some way the heir to the “self-certified” loans which British banks used to hand out so freely. These loans, which were originally intended for the self-employed or those with multiple incomes, became very popular and were widely used fraudulently, allowing borrowers to buy houses they had no business risking money on.

While self-certified loans disappeared in the aftermath of the crisis, they were replaced by so called “fast-track” loans which were also easy for mortgage brokers to game, putting borrowers in loans where few questions would be asked.

As recently as the first quarter of 2010 non-income-verified loans accounted for 43 percent of all mortgage lending in the UK, a stunning figure. The FSA is reviewing non-income-verified lending and will announce new guidelines this year.

So, the UK housing market is populated by people who are likely to have lied about their income and are increasingly likely to have been given pie-in-the-sky, interest-only loans as a way of papering over that very lack of income. What could possibly go wrong?

Well, the UK economy could easily slip into another recession, one that finally shakes the weak borrowers from the trees, bringing their houses crashing down onto the market with them.

Or, conversely, the Bank of England might be forced to raise rates to control inflation, hikes that would be very painful to the interest-only set.

Morgan Stanley is betting on a 10 percent fall in house prices before the end of 2012, a forecast predicated on 150 basis points of rate hikes in the same period.

While I am not so sure about the rate hikes, it is easy to see a 10 percent fall, a seemingly modest move but one that would put 90 billion sterling worth of negative equity mortgages on the books of Lloyds Bank. Other banks would have smaller but still meaningful exposures. Barclays Plc would be looking at negative equity mortgages of about six billion pounds, or 14 percent of its total net asset value, according to Morgan Stanley.

The whole idea of a market supported by interest-only and liar loans is unbelievable. Unbelievable, that is, until you consider how painful and disruptive the alternative will be.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)